Momentum investing

Momentum investing is a system of buying stocks or other securities that have had high returns over the past three to twelve months, and selling those that have had poor returns over the same period.[1] It has been reported that this strategy gives average returns of 1% per month for the following 3–12 months as shown by Narasimhan Jegadeesh and Sheridan Titman.[2]

While no consensus exists about the validity of this claim, economists have trouble reconciling this phenomenon, using the efficient-market hypothesis. Two main hypotheses have been submitted to explain the effect in terms of an efficient market. In the first, it is assumed that momentum investors bear significant risk for assuming this strategy, and, therefore, the high returns are a compensation for the risk.[3] It has also been shown that momentum strategies involve disproportionately trading in stocks with high bid-ask spreads and so it is important to take transactions costs into account when evaluating momentum profitability.[4] The second theory assumes that momentum investors are exploiting behavioral shortcomings in other investors, such as investor herding, investor over and underreaction, and confirmation bias.

Seasonal effects may help to explain some of the reason for success in the momentum investing strategy. If a stock has performed poorly for months leading up to the end of the year, investors may decide to sell their holdings for tax purposes. Increased supply of shares in the market drive its price down, causing others to sell. Once the reason for tax selling is eliminated, the stock's price tends to recover.

Some investors may react to the inefficient pricing of a stock caused by momentum investing by using the tool of arbitrage.

Richard Driehaus is sometimes considered the father of momentum investing but the strategy can be traced back before Richard Donchian. The strategy takes exception with the old stock market adage of buying low and selling high. According to Driehaus, "far more money is made buying high and selling at even higher prices." [5]

As computer and networking speeds increase each year, there are many sub-variants of momentum investing being deployed in the markets by computer driven models. Some of these operate on a very small time scale, such as high-frequency trading, which often execute dozens or even hundreds of trades per minute.